Discount Brokers: Disruption, Bundling, and the Battle for the Mass Affluent; Part 2

Interactive Brokers

Sustainably profiting from a commodity service like trade execution requires, at the very least, a low cost advantage, which in the brokerage space belongs to Interactive Brokers.  Despite realizing ~half the commission dollars per trade, Interactive generates the highest profit margins among its publicly traded peers.  Interactive got its start operating an electronic trading platform to pair orders for other price sensitive market makers, which required a strong bedrock of technology to pull off.  Its automated systems trounced the execution capabilities of peers who still relied on a retrograde ritual of shouting and hand gestures to match orders.  It later leveraged this technology to serve retail investors and today, its no frills automation underpins a cost base that no major discount broker can profitably match.  Schwab adopted and pioneered some interesting technology in its early days, but automation was less a philosophical imperative than an instrument to enhance customer convenience and wring inefficiencies in what was still very much a flesh and blood organization.  And Schwab’s dependence on manual processes only intensified as it assumed the responsibilities of a high touch advisor.  Interactive, on the other hand, was founded on automation (not too long after Schwab) and remains a technology company through and through, as elucidated by Christopher Steiner in this passage from his book Automate This:

“Goldman and the others on Wall Street seek out engineering talent to stock their quant departments, but at Interactive Brokers, the engineers are the company – making [founder and CEO] Peterffy’s firm something akin to Wall Street’s version of Google, a place where engineers make the product and the big decisions.  Interactive Brokers, in fact, works to ensure that 75% of its employees are programmers and engineers.  ‘Most Wall Street firms concentrate on what they do best’, Peterffy says.  ‘And that means they sell.  But we write code.  That’s what we do”.

[Thomas Peterffy, a Hungarian immigrant who grew up under Soviet occupation, founded Interactive Brokers in the 1978 (not to long after Schwab) and owns 75% of the company]

As a percent of revenue, Interactive spends less than ~1/3 on compensation and benefits than its peers, who must pay the salaries and bonuses of financial advisors and back office personnel (at Schwab, incentive compensation alone consumes 9% of revenue), and cannot leverage fixed costs to nearly the same degree as Interactive.  Self-directed traders that Schwab used to attract are now opening accounts at Interactive Brokers.  But with over half its revenue coming from net interest income [net interest earned on client cash balances and margin loans], 36% from fees [for administrative services provided to proprietary and third-party mutual funds and ETFs, and advisory], and just 7% from trading commissions, Schwab has outgrown its bygone identity as a discount broker and is today more aptly described as a fee-generating asset gatherer servicing those seeking more than just best trade execution at the lowest possible price.  Schwab and Interactive may operate in the same industry but they compete on largely different terms.

But if Schwab was willing to forsake its once sacred low-touch legacy to lay claim to a much larger market, couldn’t Interactive Brokers do the same and disrupt Schwab the same way that Schwab disrupted incumbent full service brokers?  On the surface, such a move would appear strategically ham-handed.  First, technology and automation permeates Interactive to a far greater extent than it ever was at Schwab.  Customized, high touch advice would not just constitute an organ transplant, but a wholesale gene edit.  Second, competing head on with Schwab would require opening physical branches and investing huge amounts to establish a brand with anywhere near the broad retail credibility as Schwab.  Instead, Interactive has adopted a far less culturally disjointed, more strategically congruent way of reaching the masses by going after “introducing brokers”, in essence white-labeling its automated trading platform to the tens of thousands of retail brokers around the world who cannot justify the cost of building and managing their own infrastructure.

[The introducing broker arrangement works like this: IBKR takes all the broker’s client trades and runs them through a higher volume pricing tier, and those brokers in turn charge their clients what IBKR would have charged had those clients come to IBKR directly (the introducing broker keeps 2/3 of what the client pays, IBKR gets 1/3).  While these accounts generate far lower revenue per trade, they are still quite profitable because they are unencumbered with recurring sales expenses (the introducing broker, not IBKR, interfaces with the end customer)]

But this move also trades off the customer relationship while at the same time doubling down on a revenue source whose fees are trending to zero…because while a low cost provider of a commodity product can generate sustainable value, this assumes that everyone competes on exactly the same terms.  For larger accounts, Schwab, which only gets 7% of its net revenue from trading commissions, could seemingly bundle trade execution as a veritable loss leader for spread income without dire consequences to profitability and doing so becomes all the more compelling in a rising rate environment (lost trading commissions are more than offset by higher spread income on the incremental $AUM that a zero commish policy attracts).  Schwab and Fidelity already offer commission-free ETF programs; JP Morgan, which charged $25 commissions as early as a year ago, recently announced that it would be offering its customers 100 commission-free stock and ETF trades for one year through the Chase or JP Morgan mobile app or website, with more generous trading terms for larger account sizes¹.  Schwab and these others can lean on brand and distribution to touch and profit from customers in various ways, but Interactive basically has one lever to pull, which is price (in all its instantiations…trading commissions, execution efficiency, interest paid on cash balances, interest charged on margins loans).